LONDON, Jan 21 (Reuters) - A rise in the number of banks giving up primary dealer roles in European government bond markets threatens to further reduce liquidity and eventually make it more expensive for some countries to borrow money.

Increased regulation and lower margins have seen five banks exit various countries in the last three months. Others look set to follow, further eroding the infrastructure through which governments raise debt.

While these problems are for now masked by the European Central Bank buying 60 billion euros ($65.5 billion)of debt every month to try to stimulate the euro zone economy, countries may feel the effects more sharply when the ECB scheme ends in March 2017.

Since 2012, most euro zone governments have lost one or two banks as primary dealers, while Belgium — one of the bloc’s most indebted states — is down five.

Primary dealers are integral to government bond markets, buying new issues at auctions to service demand from investors and to maintain secondary trading activity. Without their support, countries would find it harder to sell debt, forcing them to offer investors higher interest rates.

Over the last quarter alone, Credit Suisse pulled out of most European countries, ING quit Ireland, Commerzbank left Italy, and Belgium did not re-appoint Deutsche Bank as a primary dealer and dropped Nordea as a recognised dealer.

In that time, only Danske Bank has added to its primary dealer roles in the bloc’s main markets. But even Danske is worried.

“I’ve never seen it so bad,” said Soeren Moerch, head of fixed income trading at Danske Markets. “When further banks reduce their willingness to be a primary dealer then liquidity will go even lower...we could have more failed auctions and we could see a big washout in the market.”

RISING COST

Acting as a dealer has become increasingly expensive for banks under new regulations because of the amount of capital it requires, while trading profits that once made up for the initial spend have diminished in an era of ultra-low rates.

“Shareholders would be shocked if they knew the scale of the costs that some businesses are taking,” said one banker who has worked at several major investment houses with primary dealer functions.

The decline in dealers comes as many of the world’s largest financial firms, such as Morgan Stanley and Deutsche Bank, launch strategic reviews that are likely to impact their fixed income operations.

The risk that the euro zone could slide back into recession, having barely recovered from its long-running debt crisis, could exacerbate the withdrawal by prompting banks to retreat into their home markets.

“It is a negative trend. The opposite that we saw in the first 10 years of the euro,” said Sergio Capaldi, a fixed income strategist at Intesa SanPaolo. “For smaller countries...the fact that there are less players is something that could have a negative affect on market liquidity and borrowing costs.”

TOUGH OBLIGATIONS

Bankers told Reuters it was getting harder to justify the costs of being a primary dealer, even though they establish a relationship with governments that can generate other revenues in areas like derivatives and privatisations.

Seeing a once-dominant player like Credit Suisse leave in October has, for some, made it obvious that they will have to slim down if they want to continue.

A second banker, who oversees more than a dozen European dealerships, said he had told his managers he wanted to exit two countries.

Banks may also find themselves turfed out by governments if they are deemed to be doing only the bare minimum to stay in the hunt for other fee-paying business. Belgium last month did not re-appoint Deutsche Bank as a primary dealer for 2016 after conducting a performance review of all its market-makers.

“Regulation has put a lot of pressure on primary dealers,” said Victoria Webster, a fixed income specialist at financial markets trade associate AFME.

“Although the government bond markets and auctions have held up well during the crisis, banks are exiting the market whilst DMOs (debt management offices) are reconsidering the optimum number of primary dealers.”

The obligations that countries place on primary dealers vary. Some demand that they buy a defined percentage of new debt issued over the year or offer trading prices to investors for a set number of hours each day, while others are more flexible.

While it pulled out of most European markets last year, Credit Suisse has remained in Greece, where obligations are less onerous than elsewhere in the currency union.

There are signs that some governments are prepared to adapt their process in the future.

“We know markets are changing, that the process of distribution is different from what it was a few years before,” said Anne Leclerq, director of treasury and capital markets at Belgium’s debt agency.

“The fact that banks have more constraints is something that at a moment in time will push us to rethink some elements of the distribution.”

Others, though, see no need for change.

“We don’t think it’s necessary to incentivise current or prospective primary dealers. There will always be some level of turnover,” said Frank O’Connor, director of funding at Ireland’s debt agency, which saw its first dealer exit since 2009 when ING left at the end of last year. ($1 = 0.9166 euros)

Graphic by Vincent Flasseur; Additional reporting by Padraic
Halpin in Dublin and Abhinav Ramnarayan of IFR; Editing by Mark
Trevelyan